Wrongful Trading and How to Avoid it

Wrongful Trading and How to Avoid it

Every business owner starts out with the best of intentions and expects to do well. Sadly as the figures show more new start ups fail than succeed and it is important to understand that there are some legal requirements when a company gets into trouble.

One of the duties of a liquidator in any insolvency situation will be to determine whether there has been any wrongful trading on the part of the company and directors. Wrongful trading, according to The Companies Act 1986 is the act of continuing to trade even when there is no prospect of creditors being paid and there are stiff penalties for directors who don’t comply with the law.

It is important that directors stop and think about the possible consequences of trading wrongfully and in this article we look at what signs show that you may need to examine the issue and what you can put in place to give early warning of any impending problems.

It is important to remember that it is not enough to wait until absolutely certain that the company cannot continue, directors are required to take action if;

“ at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation” 1

The key phrase here is ‘reasonable prospect’. That means that the directors must take a realistic and dispassionate view of the state of play and act accordingly.

When a company is insolvent it is not a time for over optimistic forecasts that may never come to fruition. Directors have to be level headed in their assessment of the prospects for the firm.

It is not a defence to suggest that a director doesn’t have the requisite financial knowledge or information to understand the situation. It is a requirement that they apply the care of ‘a reasonably diligent person’ and that they apply the skill expected of someone taking on the office of director or if they hold a specialist office (such as finance director) the higher level of skill expected of that position.

Signs that wrongful trading may occur:

  • The company continues to make a loss with no sign of the trend reversing
  • There is no prospect of raising additional funds
  • The company loses a major customer
  • The loss of a key supplier with no replacement being found
  • Substantial debtors are in financial trouble and debts are not insured
  • There are significant onerous  or loss making contracts
  • Banks remove their facility

This is not of course an exhaustive list. The overarching principle has to be that directors take action when any event occurs that suggests the company may be in trouble. In cases such as these it is important that the board meet and discuss the future and where appropriate take specialist qualified advice. Hoping that the problem will go away or developing an unreasonably optimistic outlook are not recommended courses of action!

How can you protect yourself against a claim of wrongful trading?

There are steps you can take that will help to show that, as a director you acted responsibly and within the law. Of course it is impossible to give a remedy for absolutely every case and you won’t be protected just because you have done a few of these but these are some useful guidelines for the sort of safeguards you should be thinking about.

  • Maintain good, timely accounting records and management reports – Knowing what is going on with your company, even if it is not your area of responsibility will give you a chance of spotting problems early.
  • Ensure you have adequate training – ignorance is not a defence so ensure that you have the level of skill that allows you to understand what is happening within your company.
  • Meet regularly – and discuss as a board results not only for the past but also the future outlook. Ask the difficult questions and make sure that assertions made are tested for validity.Ensure that discussions and decisions are recorded.
  • Adopt a realistic worldview – ensure you have a basis for any optimistic forecasts and don’t just assume that everything will be OK.
  • Take action – Minimise costs and don’t continue to spend money. Taking action to reduce any possible loss to creditors shows that the directors have thought about the ramifications of continuing to trade.
  • Think about the future effects of current events – does losing a supplier mean that you can no longer manufacture your product? Will a loss making contract cause irreparable financial harm to your firm? If your main debtor goes bust how will you replace the cash lost?
  • Actively monitor and control debts – ensuring that no further liabilities are taken on and that current debts are monitored and paid down where possible shows a responsible approach to the company.
  • Take qualified advice – If there is any doubt then getting in independent experts show that the board are serious about their responsibilities to creditors.

In most cases of company insolvency directors have acted with care and responsibility. When a business goes into liquidation the creditors invariably lose out and so it is important that their losses are minimised and this is an area that a liquidator will take a look at.

Adopting these good practice principles will help immeasurably but as ever it is really important to ensure that you have taken qualified and experienced advice about your specific circumstances.

You can find a useful HMRC manual here – http://www.hmrc.gov.uk/manuals/insmanual/ins44321.htm

and the independent accountancy body ICEAW has produced a useful guide here

http://www.icaew.com/en/archive/library/subject-gateways/law/insolvency/legal-alert/when-directors-can-be-personally-liable-on-company-insolvency

 

1 http://www.legislation.gov.uk/ukpga/1986/45/section/214

Leave a Reply

Your email address will not be published. Required fields are marked *